Posts Tagged ‘trade deficit’

Awash with cash?what to do with it?

Tuesday, December 19th, 2006

Not long ago, an Australian executive went to the Middle East to promote one of his company?s software systems to potential Arab clients. In his sales pitch, he sprinkled the words ?low-cost? all over to stress the cost effectiveness of the product. After a while, one of the Arabs pulled him aside and growled, ?What do you mean by ?low-cost?? We don’t care about the cost! Just cut the nonsense and give us what we want now!? Upon returning to Australia, that executive remarked that the Middle East is ?just awash with money.?

Just where do all these money come from?

The answer, as you would have guessed by now, is the United States. The US, being in the enviable position of having its money as the world’s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners. Thus, it can sustain greater trade deficits than would otherwise be tolerated by foreigners.

For years, the US has been running a ballooning trade deficit?its imports, which is paid by its own printed dollars, has been exceeding its exports by an ever-widening margin. From China, the US has been importing consumer goods and from the oil-producing nations, oil. The US dollars that are used to buy oil are nicknamed ?petrodollars? (the money in the above-mentioned story is such dollars).

Today, those foreign countries that account for the vast majority of US imports (namely the oil-producing Middle Eastern nations, Russia, China and Japan) are sitting on so much US dollars that they do not know what to do with it. Therefore, they recycled much of those dollars by purchasing US Treasury bonds. As a result, the long-term interest rates in the US are being artificially suppressed by those purchases.

As we said before in Will the US dollar collapse?, some of these countries are murmuring about diversifying their reserves away from the US dollars because they see that such state of affair is increasingly unsustainable. With the US continually inflating its money supply (printing money), their reserves of US dollars are increasingly become more and more worthless. In fact, we believe that given the swelling amount of US dollars in the world, its current price is overvalued.

Now, here comes a problem. Countries like China and Saudi Arabia are sitting on a massive pile of US dollars parked in US Treasuries. They also know that the US dollars are overvalued and are becoming more and more worthless as each day passes. On one hand, they would not want the US dollar to collapse to its intrinsic value because that would mean the purchasing power of their US dollar reserves would be crunched. On the other hand, they would not want to continue maintaining their holdings of US dollars because they lack confidence in its value. Selling their US Treasuries at once and using the proceeds to buy alternatives to the US dollars will be unacceptable because by virtue of the magnitude of their US dollar holdings, such action will have an immediate and significant impact on the market prices. This will have a very disruptive and destabilising effect on the global financial markets. Thus, the only sensible solution is to quietly and slowly diversify away from their holdings of US dollars so as not to disturb the market prices unduly. This would take a long period of time.

The next question is, what would these countries buy to replace their US dollars?